Losses from trades or businesses—including pass‑through losses from partnerships and S corporations—are deductible only after applying four sequential limitations:
- Basis limitation
- At‑risk limitation
- Passive activity limitation
- Excess business loss limitation
A loss must pass all four tests before it can offset ordinary income.
Basis Limitation
A taxpayer cannot deduct losses exceeding their adjusted basis in a partnership or S corporation interest. Disallowed losses carry forward indefinitely and are deductible only when basis is restored.
At‑Risk Limitation
Losses are allowed only up to the taxpayer’s amount at‑risk in the activity.
A taxpayer is at‑risk for:
- Money and property contributed
- Borrowed amounts when personally liable
- Borrowed amounts secured by personal property (not used in the activity)
A taxpayer is not at‑risk for:
- Nonrecourse loans not secured by their own property
- Amounts protected by guarantees or stop‑loss arrangements
- Loans from persons with an interest in the activity (other than as a creditor)
Disallowed losses carry forward to future years for the same activity.
Passive Activity Loss (PAL) Limitation
Passive losses may offset only passive income. Excess passive losses carry forward and can be used only against future passive income.
Passive activity rules apply to:
- Individuals
- Estates
- Trusts (non‑grantor)
- Personal service corporations
- Closely held corporations
Two types of passive activities:
- Trades or businesses without material participation
- Rental activities, unless the taxpayer is a real estate professional
Material Participation Tests
Participation is material if any of the following are met:
- 500 hours
- Taxpayer performs substantially all participation
- 100 hours and at least as much as anyone else
- Significant participation activities totaling >500 hours
- Regular, continuous, substantial participation (facts and circumstances)
- Material participation in 5 of the last 10 years
- Material participation in a personal service activity for 3 prior years
Rental Real Estate Exceptions
A rental loss may offset ordinary income if:
- Real Estate Professional
- 50% of personal services in real property trades or businesses
- 750 hours of material participation
- $25,000 Special Allowance
- Active participation (approving tenants, rental terms, expenses)
- Full $25,000 allowed if MAGI ≤ $100,000
- Phased out 50% between $100,000–$150,000
- No allowance if MAGI ≥ $150,000
Excess Business Loss Limitation
Made permanent by the One Big Beautiful Bill Act.
An excess business loss occurs when:
Total business deductions minus Total business income/gains minus Threshold amount
exceeds the annual limit.
For 2025, the threshold is:
- $313,000 (single)
- $626,000 (joint)
Disallowed excess business losses become net operating loss (NOL) carryovers.
Applies at the partner/shareholder level for partnerships and S corporations.
Not‑for‑Profit Activities (Hobby Loss Rules)
If an activity lacks a profit motive, losses cannot offset other income.
Presumption of profit if:
- Profit in 3 of 5 years, or
- Profit in 2 of 7 years for horse‑related activities
Deduction Categories (Only if itemizing)
- Category 1: Personal‑type deductions (mortgage interest, taxes, casualty losses)
- Category 2: Business‑type expenses (rent, wages, supplies)
- Category 3: Basis‑adjusting expenses (depreciation, amortization)
Category 2 and 3 expenses were previously miscellaneous itemized deductions, but the One Big Beautiful Bill Act permanently eliminated deductions subject to the 2% AGI floor.